In our last episode, we discussed the dangers of investing with triple leveraged exchange traded funds. That encouraged me to take a step back and answer one of the most common and important questions an investor encounters when creating a portfolio: What is risk management? Defining risk management is easy — implementing some of the strategies is where it can get tricky.
What is Risk Management?
First, let’s define risk. Risk is simply the probability of something bad happening to an investment or to your portfolio — the realization that you can lose money as an investor. It’s easy to associate risk with financial loss, and we all would love to have losses eliminated from our portfolios, but that just isn’t the way the market works. We have to do our research before adding a stock to our portfolio, then we must have strategies to sell that stock or hedge our portfolio or implement some other metric of dealing with the risk of financial loss. Therefore, we can define risk management simply as the technique, strategy, or tactic to assess, determine, and minimize the possibility of loss in our portfolio. Notice, the words “eliminate loss” aren’t part of the definition because risk will always be part of a solid investment strategy. There are things you can do to increase your risk, like trade leveraged ETFs, or trade on margin in your account, or perhaps trade highly volatile stocks, but a winning investor seeks to minimize risk as much as possible without overdoing it. Of course, if you wanted to eliminate risk completely, you could simply stay out of the market, but that’s going too far. There has to be a balance between the possibility of financial gain and the possibility of loss. Risk is part of the game! You purchase car insurance to prevent significant financial loss from an accident, and you buy home insurance to prevent a catastrophic financial loss should something terrible happen to your house. Buying insurance is probably the best way to start a discussion of risk management in the market. Your small monthly or quarterly insurance payments are part of your risk management strategy for your investment in your home or car. There are similar ways to create ”insurance” as you build your portfolio.
Ways to Manage Risk – Option 1
We’ve discussed hedging strategies in prior episodes, and we’ve discussed asset allocation. Those are two main ways investors seek to manage portfolio risk. Asset allocation means shifting a percentage of your portfolio to more conservative investments like bonds, and away from riskier investments like stocks if you feel the stock market may be in for a decline in the near future. Of course, if you felt the stock market was trending higher and economic conditions were improving, you would want to shift a larger percentage into stocks and remove any sort of hedges you had in place. A simple way to manage risk is with stop-losses. For example, when you purchase a stock after doing your homework, you might decide to sell the stock if it declines 8% or 10% lower than your purchase price. That is the most common form of risk management — the stop-loss order. In other words, you decide in advance how low the stock can decline before you sell the position and add a new stock in its place, thus preventing the possibility of a 10% stock loss to creep up to a 20% or 30% loss months in the future.
Ways to Manage Risk – Option 2
Another strategy some investors use to manage risk is to purchase options. The easiest way is to purchase “put options” to protect positions in some of the stocks in your portfolio. Put options increase in value as the price of the stock declines. They also work very much like insurance in that you pay a fee upfront in the event a stock that you own declines in value. Let’s say you bought a stock at $50 per share and it has now risen to $60 per share. You think there may be a slight decline but you want to continue holding the position in your portfolio and don’t want to sell it. You might decide to buy a “put” at $55 per share for protection. As long as the price of the stock remained above $55 per share, you would lose the money on your put just like you lose the money you pay for insurance when nothing bad happens to your home or car. However, if your stock fell sharply to $50, you would be protected at $55 per share and could sell your stock at $55 per share instead of the current market value at $50. This puts a floor under the price for your protection. Ways to Manage Risk – Option 3 Alternately, you could employ a “covered call” strategy, similar to what we discussed in a prior episode. When you own a stock, you would sell a call above the current value of the stock and immediately collect the money from the sale of the option. You get to keep that money no matter what the stock does, so it can add a bit of buffer to a flat or sideways stock. In the event the stock price rose sharply above your strike price, you would be forced to sell your shares at your higher strike price, and you would miss an opportunity for any price gain above your strike price. Of course, if your stock declined very sharply, the few hundred dollars you received for the sold call would not fully cover the thousands of dollars you might lose in a sharp stock decline.
Summary: 5 Risk Management Tools
- Hedge your portfolio, perhaps with inverse ETFs
- Practice asset allocation percentages between different markets — especially stocks and bonds
- Use fixed percentage stop losses
- Buy put options
- Sell call options
Stay with us as we discuss more ways to develop your own risk management strategies in future episodes. And, of course, consider picking up a copy of my latest book The Winning Investor’s Guide to Making Money in Any Market at Amazon and other fine booksellers, and in print and digital versions too! Want to become a Winning Investor? Then be sure to get your copy today – The Winning In Read the rest of article…